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Corporate Financial Policy:

Risk, Return and the CAPM

Jide Wintoki (University of Kansas)

Jide Wintoki

Fall 2013

Business Investment (FIN 468)

Fall 2013 1 / 13
Fall 2013
1 / 13

Lecture Outline

The Relationship Between Risk and Return

The Security Market Line

Calculating Individual Stock Betas

Validity and the Role of the CAPM

Some Alternative Theories

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 2 / 13
Fall 2013
2 / 13

Risk and Return

The return earned on investments represents the marginal benefit of investing.

Risk represents the marginal cost of investing.

For any project to create value, the marginal benefit must exceed the marginal cost of investing.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 3 / 13
Fall 2013
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Project or asset risk

In general, the risk of investing in any project or holding any asset consists of two components:

Undiversifiable risk (systematic risk, market risk)

Only systematic risk is priced in the market.

This is the only type of risk that is relevant for capital budgeting or asset valuation.

Beta is one way to measure the systematic risk of an asset.

Diversifiable risk (unsystematic risk, idiosyncratic risk, or unique risk)

Investors do not care about unsystematic risk because it can be diversified away very cheaply.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 4 / 13
Fall 2013
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Capital Asset Pricing Model (CAPM)

E(R i ) = R f + β i [E(R m R f )]

Only beta changes from one security to the next. For that reason, analysts classify the CAPM as a single-factor model, meaning that just one variable explains differences in returns across securities.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 5 / 13
Fall 2013
5 / 13

The Security Market Line

Plots the relationship between expected return and betas In equilibrium, all assets lie on this line

If stock lies above the line:

Expected return is too high Investors bid up price until expected return falls

If stock lies below the line:

Expected return is too low Investors sell stock, driving down price until expected return rises

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 6 / 13
Fall 2013
6 / 13

The Security Market Line

E(R P ) A - Undervalued SML • • A Slope Premium = E(R (MRP)
E(R P )
A - Undervalued
SML
A
Slope Premium = E(R (MRP) m ) - R F = Market Risk
R
M
B
R
F
B - Overvalued
β =1.0
β i

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 7 / 13
Fall 2013
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Beta

β i = σ im

σ

2

m

The numerator is the covariance of the stock with the market.

The denominator is the market’s variance.

In the CAPM, a stock’s systematic risk is captured by beta.

The higher the beta, the higher the expected return on the stock.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 8 / 13
Fall 2013
8 / 13

Beta And Expected Return

Beta measures a stock’s exposure to market risk

The market risk premium is the reward for bearing market risk:

R m R f

E(R i ) = R f + ß [E(R m ) – R f ]

• bearing Return for no (risk-free market risk rate) •
• bearing Return for no
(risk-free market risk rate)
Stock’s market (beta) exposure risk to • bearing Reward risk (market market for premium)
Stock’s
market (beta) exposure risk to
• bearing Reward risk (market market for
premium)

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 9 / 13
Fall 2013
9 / 13

Calculating Expected Returns

E(R i ) = R f + β i [E(R m R f )]

Assume

Riskfree rate = 2% Market risk premium = 6%

If Stock’s Beta Is

Then Expected Return Is

0

2%

0.5

5%

1

8%

2

14%

When Beta = 0, The Return Equals The Risk-Free Return When Beta = 1, The Return Equals The Expected Market Return

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 10 / 13
Fall 2013
10 / 13
Using The Security Market Line The SML and where P&G and GE place on it
Using The Security Market Line
The SML and where P&G and GE place on it
r%
SML
15
12.4%
slope MRP = ΔY ÷ = = ΔX 10% E(R m - ) 2% – R = F = 8%
10
6.8%
5
R f = 2%
P&G
1
GE
2 β

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 11 / 13
Fall 2013
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Alternatives To CAPM

Arbitrage Pricing Theory

R i R f = β i1 (R 1 R f )+β i2 (R 2 R f )+β i3 (R 3 R f

Fama-French Model

.+β in (R n R f )

R i R f = α + β i1 (R m R f ) + β i2 (R small R big ) + β i3 (R high R low )

Betas represent sensitivities to each source of risk. Terms in parentheses are the rewards for bearing each type of risk.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 12 / 13
Fall 2013
12 / 13

The Current State of APT

Investors demand compensation for taking risk because they are risk averse.

There is widespread agreement that systematic risk drives returns.

You can measure systematic risk in several different ways depending on the asset pricing model you choose.

The CAPM is still widely used in practice in both corporate finance and investment-oriented professions.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013 13 / 13
Fall 2013
13 / 13